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Finding Alpha: The Search for Alpha When Risk and Return Break Down

ISBN: 978-0-470-44590-7
298 pages
June 2009
Finding Alpha: The Search for Alpha When Risk and Return Break Down (0470445904) cover image
Praise for Finding Alpha

"Eric Falkenstein is more than one of the smartest and funniest people in finance. He's been a banker, a key model builder at a major rating agency, and a hedge fund trader. In this tour de force, he outlines the successes and failures of financial theory applications in the real world from the perspective of an aggressive early adopter of the best ideas in finance. To this day, I think Eric's private firm default model is one of the best papers ever published in applied finance, and this wonderful book falls into the same category."
Donald R. van Deventer, PhD, founder and Chief Executive Officer, Kamakura Corporation

"People dismissed Columbus when he said the world was round. Thank goodness he persisted. Like Columbus, Falkenstein challenges standard thinking, only this time about risk and reward. As the meltdown of the capital markets has shown, the financial industry clearly missed something with regard to risk management. As an industry, we need to consider alternative theories on risk, and clearly Falkenstein is on to something here. Agree with him or not, Finding Alpha is worth a read."
Kevin M. Blakely, President and CEO,The Risk Management Association

"Writing through the lens of an experienced practitioner, Falkenstein digests decades of research in capital markets, financial economics, and investment psychology that have shaped modern investment theory. This text is an excellent companion for portfolio managers, investment students, or anyone seeking to better understand the relationship between risk, returns, and financial reward."
Todd Houge, PhD, CFA, The University of Iowa

How do we find alpha whenrisk does not correlate with return?

Finding Alpha is a practical guide to achieving alpha when conventional measures of risk rarely correlate with higher returns. Author Eric Falkenstein-a PhD who has also been a risk manager and portfolio manager—tells the story of alpha from its beginnings to its current reversal, where risk is now evidenced by return as opposed to vice versa.

Falkenstein begins by walking readers through the Capital Asset Pricing Model (CAPM), as well as other well-documented theories about risk and return, and explores how these theories measure up to current empirical evidence being documented by researchers and academics. He also outlines a novel approach to the issues of how benchmark risk and investor overconfidence affects expected asset returns, how to understand the nature of alpha and risk, and how to use practical applications of alpha-seeking strategies that he developed as a successful hedge fund manager.

Finding Alpha concludes by outlining some real-life applications of alpha in finance and explains how the search for alpha affects the day-to-day life of all financial professionals.

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CHAPTER 1 Risk Uncorrelated with Returns.

The Response: Return (Risk (Return)).

Failed Paradigms.

You Minimize Some Risks, Pay to Take Others.

CHAPTER 2 The Creation of the Standard Risk-Return Model.

The CAPM.

Pillar 1: Decreasing Marginal Utility Means Risk Aversion.

Pillar 2: Diversification Means Not All Risk Is the Same.

The Arbitrage Pricing Theory (APT).

The Stochastic Discount Factor (SDF).

Adding Non-Normality.

The Uncertainty Revival.

CAPM: A Special Case of the Stochastic Discount Factor Model.

CHAPTER 3 An Empirical Arc.

The Beginning of the End of CAPM.

APT Tests.

Fama and French Put a Fork in the CAPM.

Saving the Standard Model.

Serial Changes to APT.

Skewness.

Analogy to Business Cycle Forecasting.

Summary.

CHAPTER 4 Volatility, Risk, and Returns.

Total Volatility and Cross-Sectional Returns.

Beta-Sorted Portfolios.

Call Options.

Small Business.

Leverage.

Mutual Funds.

Futures.

Currencies.

Lotteries.

Movies.

World Country Returns.

Corporate Bonds.

The Long End of the Yield Curve.

Distress Risk.

Sports Books.

Total Volatility and Expected Equity Index Returns.

Uncertainty and Returns.

IPOs.

Trading Volume.

Volatility as Shorthand for Risk.

CHAPTER 5 Investors Do Not Mind Their Utility Functions.

Behavioral Violation 1: Investors Trade Too Much.

Behavioral Violation 2: Too Many Funds.

Behavioral Violation 3: Underdiversification.

Behavioral Violation 4: No Fundamental Analysis.

Behavioral Violation 5: Buy Recommendations Exclude Firms with Merely Low Risk.

Behavioral Violation 6: Agents Do Not Agree.

Behavioral Violation 7: The Home Bias.

The Rotten Core: The Utility Function.

Absurd Extrapolations.

Easterlin’s Paradox.

Summary.

CHAPTER 6 Is The Equity Risk Premium Zero?

Geometric versus Arithmetic Averaging.

Survivorship Bias.

Peso Problems.

One-time Effect of an Anomalous Post-Depression Period.

Asymmetric Tax Effects.

Market Timing.

Transaction Costs.

Summary.

CHAPTER 7 Undiminished Praise of a Vacuous Theory.

CHAPTER 8 Why Relative Utility Generates Zero-Risk Premiums.

Benchmark Risk.

Why Relative Risk Leads to No Risk Premium.

CHAPTER 9 Why We Are Inveterate Benchmarkers.

Typical Economic Assumptions.

Virtue of Selfishness.

Why Envy Is Virtuous.

Why Economists Dislike Envy in General.

CHAPTER 10 Alpha, Risk, and Hope.

The Search for Safety.

Most Financial Risk Takers Are Foolish.

Two Types of Priced Risk.

Uncertainty in Innovation.

Why Risk Taking Hurts.

Confusion of Risk and Gambling.

Standard Alpha Contradiction.

Why We Take Risk Anyway.

Experiments, Risk, and Alpha.

CHAPTER 11 Examples of Alpha.

Finding the Right Alpha.

Arbitraging Put-Call Parity.

Convexity Trade in Futures and Swaps.

Pairs and Mean Reversion.

Fund Innovations.

Convertible Bonds.

Long and Short Equity Hedge Funds.

Automating Activities.

Conclusion.

CHAPTER 12 Alpha Games.

Benign Deception.

The Favor Bank.

Managerial Alpha.

The Alpha in Risk Management.

A Singular Risk Management Decision.

Risk Management Like Audit.

Overpaid Alpha Deceptors.

Investor Meets Alpha.

CHAPTER 13 Alpha Seeking Applications.

Minimum Volatility Portfolio.

Beta Arbitrage.

Investing in Anomalies.

Safety Investing.

Hope Investing.

Relative Risk and Bubbles.

Capital Finding Alpha Strategies.

Search for Alpha.

CHAPTER 14 Conclusion.

Notes.

Index.

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Eric Falkenstein, PhD, developed the RiskCalcTM, the world's leading scoring tool for evaluating private firm default risk, while at Moody's Risk Management Services. The celebrated tool is used by banks worldwide, as well as by regulators and Moody's own CDO group. He was head of capital allocations and quantitative modeling at KeyCorp prior to joining Moody's and later was with Deephaven Capital Management where he developed and managed a long/short equity strategy. Between 1996 and 2002, Falkenstein formed his own investment company, the Falken Fund, which had returns of 16.0% versus 3.8% for the S&P500. His hedge fund activities are ongoing and, by law, proprietary. He is a consultant and a member of CapRock Advisors LLC, a hedge fund advisor.
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